AQA Specification focus:
‘The main functions of a central bank.’
Introduction
Central banks are crucial institutions within modern economies, managing monetary policy, regulating the financial system, and maintaining stability. Their core functions influence growth, inflation, and financial confidence.
Core Functions of a Central Bank
Issuer of Currency
The most visible function of a central bank is its role as the sole issuer of currency. This ensures uniformity, public trust, and stability in the nation’s money supply.
Currency Issuer: The legal authority of the central bank to produce and circulate a nation’s banknotes and coins, recognised as legal tender.
By centralising this function, the central bank prevents counterfeiting, creates confidence in money, and safeguards its role as a medium of exchange.
Lender of Last Resort
Central banks act as the lender of last resort to commercial banks in times of crisis. This function protects financial stability by providing emergency liquidity.
Lender of Last Resort: The role of the central bank in providing short-term loans to commercial banks when no other source of funds is available.
For example, during financial crises, this prevents a collapse in confidence that could spread throughout the economy.
Implementing Monetary Policy
A central bank is responsible for monetary policy, which involves actions to influence interest rates, money supply, and credit conditions. This is central to stabilising the economy.
Key tools include:
Policy interest rates (e.g., Bank Rate in the UK).
Open market operations to manage liquidity.
Quantitative easing to stimulate demand when rates are low.
These instruments allow the bank to pursue objectives such as low inflation and steady economic growth.
Price Stability and Inflation Targeting
Maintaining price stability is often the primary goal. Many central banks operate with a government-set inflation target, ensuring predictable economic conditions.
Price Stability: A situation in which inflation is low and stable, avoiding both runaway inflation and deflation.
In the UK, the Bank of England aims for an inflation target of 2%, balancing growth with sustainable purchasing power.
Maintaining Financial Stability
Another critical function is to safeguard the stability of the financial system. The central bank monitors systemic risks and takes steps to prevent financial crises.
This involves:
Supervising banks and financial institutions.
Acting against excessive risk-taking.
Coordinating with regulators to maintain confidence.
Such measures limit the danger of systemic collapse.
Managing Foreign Exchange and Reserves
Central banks also hold foreign currency reserves and manage the exchange rate where appropriate. This supports international trade and protects against currency volatility.
Functions include:
Stabilising the exchange rate through intervention.
Building reserves to protect against external shocks.
Managing payments to ensure smooth global trade.
Controlling Money Supply and Credit
Central banks influence the growth of the money supply and the availability of credit in the economy. By regulating credit conditions, they balance growth and stability.
Methods include:
Adjusting reserve requirements for banks.
Using interest rate changes to expand or restrict lending.
These measures ensure credit is available but not excessive.
Supporting Functions of a Central Bank
Regulator of Commercial Banks
Although some supervisory tasks fall to separate regulators, central banks often play a role in overseeing commercial banks. They ensure that these institutions maintain adequate capital ratios and follow safe lending practices.
This enhances public trust in the banking system.
Managing National Debt
Central banks may assist governments in managing public debt by issuing and buying government bonds. While not always the primary function, this can reduce borrowing costs and stabilise markets.
Independence and Credibility
A critical modern function is to maintain independence from political pressures. Independent central banks are more credible and effective in controlling inflation, as their decisions are based on economic analysis rather than short-term politics.
Central Bank Independence: The ability of the central bank to set monetary policy free from direct government influence.
This independence strengthens credibility, ensuring that inflation expectations remain stable.
Summary of Key Roles
Central banks combine multiple vital roles:
Issuing currency and ensuring monetary stability.
Acting as lender of last resort during crises.
Implementing monetary policy to target inflation and growth.
Maintaining financial stability by monitoring systemic risks.
Managing exchange rates and reserves.
Supporting safe banking practices and managing government debt when necessary.
Together, these functions ensure a stable financial environment that supports sustainable economic growth.
FAQ
Independence ensures that monetary policy decisions are based on economic conditions rather than political pressures. Politicians may prefer short-term growth, even at the cost of higher inflation.
An independent central bank can maintain credibility, anchor inflation expectations, and prevent inflationary policies during election cycles. This helps keep inflation stable and predictable.
In normal conditions, the central bank focuses on steady inflation and stable growth by adjusting interest rates and managing money supply.
During crises, its role as lender of last resort becomes crucial. It provides emergency liquidity, expands credit availability, and reassures markets to prevent systemic collapse.
Public trust is central to financial stability. The central bank builds confidence by:
Issuing secure currency that is widely accepted.
Monitoring risks and intervening when banks face liquidity issues.
Communicating policy decisions clearly to avoid uncertainty.
This confidence reduces the likelihood of bank runs and market panic.
Foreign exchange reserves allow central banks to intervene in currency markets. They can buy or sell their own currency to influence its exchange rate.
Reserves also act as a buffer against external shocks, such as sudden capital outflows or trade imbalances, ensuring stability in international transactions.
Zero inflation may sound ideal, but it risks deflation if prices fall slightly. Deflation reduces spending and investment, slowing economic growth.
A low but positive inflation target, usually around 2%, provides:
Incentives for borrowing and investment.
Flexibility for wages and prices to adjust.
Protection against deflationary spirals.
Practice Questions
Define the term lender of last resort in the context of a central bank. (2 marks)
1 mark for stating that the central bank provides emergency funds/short-term loans to commercial banks.
1 mark for explaining that this happens when no other source of funds is available, usually in a crisis.
Explain two key functions of a central bank, other than acting as a lender of last resort. (6 marks)
Up to 3 marks for each function explained.
Award 1 mark for identifying a valid function (e.g. issuing currency, implementing monetary policy, maintaining financial stability, managing foreign exchange reserves, controlling money supply, ensuring independence).
Award 1 additional mark for developing the explanation of how this function works.
Award 1 further mark for linking the function to its importance or effect on the wider economy (e.g. issuing currency builds trust and uniformity; implementing monetary policy stabilises inflation and growth).
Maximum of 6 marks overall.
